Will the VIX hit all time low? And just what is the “real” fear index saying?

May 11, 2017 | Tama Churchouse

The VIX (often called the “fear index”) has in recent weeks been close to its all-time lows. One way of interpreting this is that as an investor, you have nothing at all to worry about when it comes to the U.S. equity market. Other people think that this is precisely the time to be the most worried.

Is this VIX’s all time low? Well VIX historical data shows it has only ended the day below 10 on 11 days out of 6,893 in 37 years (since January of 1990).

But a different “fear index” suggests that investors are being too complacent…

A different measure of “fear”

You’re likely to be familiar with the concept of what we call in finance a “black swan” event. The term was popularized by the academic and author Nassim Nicholas Taleb to describe a major unexpected market event.

It’s often an event that is heavily rationalized afterwards with the benefit of hindsight. The 2008 sub-prime crisis, the trigger for the global economic crisis, is a good example of this.

In the context of black swans, you may hear reference to something called “tail risk”.

Tail risk simply represents the probability of a black swan event occurring – that is, like a stock market crash, or a major correction.

You see, VIX doesn’t really tell us anything about how the market views tail risk (i.e. the probability of a black swan event). It just tells us about the absolute level of expected volatility.

But there’s another indicator that can. It’s called the CBOE Skew Index, or just SKEW.

This index uses the prices of S&P 500 Index options to measure the perceived tail risk of the S&P 500 over a 30-day horizon.

It does this by looking at how much investors are willing to pay for downside protection (i.e. put options) relative to upside (i.e. call options).

The more downside protection the market wants, the higher the price of put volatility relative to call volatility, and hence the higher the level of SKEW.

In other words, this index tells us how worried the market is about a near-term black swan event.

Take a look at the image below. It shows the VIX historical chart alongside the SKEW index.

The SKEW index is a messy one (I’ve used the 3-month moving average to smooth out the chart), but the trend is clear: Whilst volatility has continued to decline, SKEW is trending up.

In fact, in March of this year, the SKEW index hit its highest ever level (for the available data going back to January 1990).

Far from saying everything is OK, this fear indicator is telling us the opposite… that the market is increasingly paying more for downside insurance against a black swan event. So there’s more concern about it.

Does this mean that there’s going to be a sharp market correction tomorrow? No. SKEW has been trending upwards since 2008, as you can see in the chart.

However, given that it is elevated and has just hit an all-time high, it does imply that the risk of a sharp correction is rising.

P.S. As I write this, our recommendation from the latest edition of The Churchouse Letter is up 6.7 percent in less than 2 weeks. But I expect it to go a lot higher. I’ll be joining a company call later this month, and if I hear what I expect to, the stock could easily jump another 10 to 20 percent in a matter of days. Click here for your no-risk trial subscription to The Churchouse Letter and get the full details.

About Tama Churchouse

Tama Churchouse spent nearly a decade creating and selling financial derivatives for a global investment bank in Hong Kong. As Lead Analyst he brings technical expertise across the entire asset class spectrum, from equities and index products, to interest rates and credit.

SUBSCRIBE NOW

As a relatively new subscriber to your Asian Investment Daily, I want to thank you for the exceptionally well-written articles. Your articles are invariably easy to understand, logical, and informative”